TAX COMPETITION WITH PARASITIC TAX HAVENS Joel Slemrod University of Michigan John D. Wilson Michigan State University

Tax Haven: A jurisdiction that imposes no or only nominal taxes itself and offers itself as a place to be used by non-residents to escape tax in their country of residence. A tax haven can offer this service because it has laws or administrative practices that prevent the effective exchange of information on taxpayers benefiting from the low-tax jurisdiction. We refer to the intent of such jurisdictions as being “parasitic” on the tax revenues of the non-haven countries.

Purpose of paper: Develop a theory of tax havens and tax competition that explains why countries are, and should be, concerned about the detrimental effects of havens on their citizen’s welfare OECD report: “Governments cannot stand back while their tax bases are eroded through the actions of countries which offer taxpayers ways to exploit tax havens [and preferential regimes] to reduce the tax that would otherwise be payable to them.”

Existing Literature: Tax havens are good. The presence of the haven reduces the (distorting) effective marginal tax rate on mobile capital for any given statutory tax rate. Critical Assumption: Countries are unable to explicitly differentiate the statutory tax rates on mobile and immobile capital; tax havens overcome this constraint.

Our Results 1. Tax havens lead to the wasteful expenditure of resources. 2. Tax havens worsen tax competition problems by causing countries to further reduce their tax rates below levels that are efficient from the viewpoint of all countries combined. 3. Either full or partial elimination of havens is welfare- improving. 4. Partial elimination can leave all countries better off, including the remaining havens. 5. Unlike the havens-are-good literature, we endogenize the relative statutory rates at which mobile and immobile factors are taxed; mobile capital is taxed because collecting taxes on immobile labor is costly (tax evasion).

Standard Tax Competition Model N countries; identical except for size, measured by number of workers, L. Residents value private goods (x) and publicly provided private goods (g). Residents budget constraint: c = w + rK*, where w and r are the wage and expected after-tax return on capital.

Constant-returns production technology  Competitive firms use internationally immobile labor and internationally mobile capital to produce output. Output is sold as the private consumption good, and is also sold to the government for use as the sole input in producing the public good. The public good is financed by taxing wage and capital income. The business tax system is treated as “territorial,” meaning that each government taxes only the capital income earned within its borders.

The model with tax havens: timing of events Each country’s government chooses its tax rates, t on capital income and  on wage income, and its expenditures on “tax enforcement,” b per firm. Investors create firms using one unit of capital per firm, which they invest where the expected after-tax return is highest. Firms learn the value of a random cost parameter, , representing a fixed cost that must be paid to shift income internationally for tax purposes.

Firms purchase labor and produce output, and those firms with low  ’s purchase “concealment services” from competitive tax havens at the unit price, p = p(C), where C = worldwide purchases. The supply curve, p(C), is infinitely elastic or upward-sloping. (For now, assume a fixed number of havens.) Before-tax return on capital (a firm’s “before-tax profits”): R = f(L/K) – w(L/K)(L/K); L/K = country labor-capital ratio.

After-tax return: = R[1 –(pc + θ) – t(1 - s)] where c = a firm’s concealment purchases; pc+  = total cost of concealment;

s = s(c, b) = income-shifting function; tRs = tax savings from income shifting.

The return on capital The before-tax return on capital, R, exceeds r for two reasons: taxes and the deadweight losses associated with tax havens. R = r + T + D K

Effective Tax Rate: T = tR(1 – αs) - b; Deadweight Loss: D K = R( α( pc + E(  <  ))) + b; where α  share of firms participating in tax havens (α  G(  ), where G(  ) is the distribution function for  )

Wage Taxation Effective tax rate on wage income: . Deadweight Loss: D L = D L (W,  ).

The Government Optimization Problem: Maximize u(x, g), subject to Government Budget: g = Tk(R ) + . Resident’s Budget: x = rk* + W(R) -  - D L (W(R),  ). Before-tax return: R = r + T + D K (r, T, b, p ).

The rule for a country’s optimal pubic good level Financed with Wage Taxation: ≡ MC . Financed with Capital Taxation: ≡ MC T, where  = capital demand elasticity.

Proposition 1. Countries tax both labor and capital Basic argument: If t = 0, then raising t causes no first-order efficiency loss in capital markets, but the resulting reduction in the wage reduces the costs of tax evasion in the labor market (the term), implying that MC T 1 (see below).

Proposition 2. The elimination of tax havens raises the equilibrium level of the public good and increases country welfare. Underprovision of the public good: ≡ MCT > 1

Two reasons for underprovision relative to first-best: A fiscal externality: Each country treats as a cost the capital outflow that occurs when it raises its tax rate, but this outflow represents a beneficial inflow for other countries.

A higher tax rate increases the deadweight losses from tax evasion, which is reflected in a higher before-tax return R, leading to a lower wage ( in the numerator) and a higher capital outflow ( multiplying the capital elasticity). If tax havens are eliminated, then these deadweight losses disappear and the fiscal externality becomes less severe (because dR/dT = 1, rather than dR/dT = 1 + ).

Partial Elimination of Tax Havens A benefit from partial elimination: Higher price of concealment services (p). Lemma 1. Under some conditions on s(c/b), if b > 0 in equilibrium, then a rise in the unit price of concealment services raises a country’s welfare.

Basic argument: The increase in p enables countries to reduce their enforcement expenditures, b, without causing the amount of concealment services to rise. Since b is financed out of the government budget, countries are then able to increase public good provision or reduce the wage tax.

Proposition 3. By increasing the concealment price p, a reduction in the number of havens causes all countries to increase their public good provision. Provided tax competition leads to underprovision of the public good, this reduction in havens must raise welfare.

Enforcement Expenditures Basic Argument: Enforcement expenditures create a negative externality: they cause firms to reduce purchases of concealment services, which lowers the equilibrium price, p, causing welfare to fall in all countries. A tax reduction similarly lowers p. Conclusion: Countries would be better off if they financed their public goods with higher taxes and lower enforcement.

Proposition 4. Under some assumptions, countries enforce their capital tax collections too stringently. In particular, if each country reduces its enforcement level by the same amount, while adjusting its capital tax t to keep its cost of capital unchanged, given the equilibrium r and p, then p will rise and all countries will be better off.

Country Size and Tax Havens The cost of becoming a haven is modeled as a suboptimal tax system (zero capital tax in our model).  This cost per resident is independent of country size. The benefit is the “profits” from the sale of concealment services.  These profits are independent of country size, and so profits per resident decline with size.

An alternative factor that might limit the provision of concealment services is that countries undertake activities to shut havens down, the more services they provide. Here the cost of providing more concealment services, an increased probability of being shut down, is (also) not based on the size of the country.

Conclusions  The smaller countries become havens.  An increase in the price of concealment services causes larger countries to choose to become havens, implying an upward-sloping supply curve for concealment services.  If the number of havens is restricted, starting with the larger havens, then non-haven countries are better off (higher p), and all countries and havens are better off if the restriction is small.  Large restrictions: Small havens that are forced to give up haven status may be worse off.

Final Remarks We have developed a theory of tax havens and tax competition that justifies concerns about the detrimental effects of havens on welfare. The elimination of a sufficiently small number of havens will leave all countries better off. The analysis points to the potential difficulties involved in eliminating large numbers of havens, including small ones.